Quick Answer
Mutual funds are pooled investments regulated under the Investment Company Act of 1940. A conventional mutual fund is an open-end fund that continuously issues and redeems shares at NAV, priced once daily using forward pricing, and is bought and sold directly with the fund rather than on an exchange. Closed-end funds issue a fixed number of shares in an IPO, then trade on an exchange at a market price that can sit above or below NAV.
The exam leans on that open-end versus closed-end split constantly, so get comfortable naming which structure a fact pattern describes before you look at the answer choices.
What Are the Three Statutory Types Under the ICA?
This federal law (commonly called the ICA) governs how investment companies operate and classifies them into three statutory types:
| Category | What It Does | Portfolio Changes? |
|---|---|---|
| Face-Amount Certificate (FAC) | Promises to pay a set amount on a future date | N/A (obsolete) |
| Management Company | Professionals select and trade securities | Yes (active) |
| Unit Investment Trust (UIT) | Holds a fixed basket of securities until maturity | No (static) |
Face-amount certificates are obsolete. Open-end and closed-end funds are management companies. Private funds (hedge funds, private equity, venture capital) avoid ICA registration via the small-investor private-fund exemption (under 100 holders) or the qualified-purchaser private-fund exemption.
How Do Open-End Funds (Mutual Funds) Work?
Open-end funds continuously issue and redeem shares. There is no fixed number of shares outstanding. Shares are created on purchase and retired on redemption.
How they work:
- Investors buy and redeem directly with the fund (no secondary market trading)
- Purchased at the public offering price (POP) = net asset value (NAV) + sales charge
- Redeemed at NAV
- Cannot be purchased on margin or sold short
- Sold by prospectus (summary or statutory)
- Fund must redeem shares within 7 calendar days
- Must register with the SEC under the ICA
- Restricted under the ICA to issuing a single class of security, common stock: no bonds, preferred stock, or other senior securities. This limits how the fund raises its own capital; it does not limit what the fund's portfolio can hold (bonds, preferred stock, and other securities are all fair game as investments)
- Board of directors oversees the fund (including independent/non-interested directors)
- Classified as diversified or non-diversified under the ICA's diversification requirement
- 75/5/10 test: for at least 75% of the fund's assets, no more than 5% can go into any single issuer, and the fund can hold no more than 10% of that issuer's voting securities
- The remaining 25% of assets isn't subject to these limits; a fund that doesn't meet the test is non-diversified
Net Asset Value (NAV):
- Calculated once daily after markets close (4:00 PM ET)
- Forward pricing: orders received before 4:00 PM ET get that day's NAV; orders received after get next day's NAV
Exam Tip: Gotchas
- Conventional mutual fund shares are NEVER traded on an exchange. They are bought from and redeemed directly with the fund company. If a question describes shares trading at a premium or discount to NAV, it is NOT a conventional mutual fund. Be careful with the term "open-end fund" itself: under the Investment Company Act it also covers ETFs, which DO trade on an exchange and can trade at a premium or discount, so "open-end" alone does not rule that out.
- The common-stock-only rule limits issuance, not investment. An open-end fund can only issue one class of security (common stock) to raise its own capital, but that rule says nothing about the portfolio. The fund can still invest in bonds, preferred stock, and other securities.
How Do Closed-End Funds Differ From Open-End Funds?
Closed-end funds issue a fixed number of shares through an IPO. After the IPO, no new shares are created.
How they work:
- After IPO, shares trade on exchanges (NYSE, Nasdaq) like stocks
- Do NOT redeem shares; investors buy/sell on the secondary market
- Can trade at a premium (above NAV) or discount (below NAV)
- Market price determined by supply and demand, not just NAV
- Can use leverage (borrow money, issue preferred shares, or issue debt)
- Can be purchased on margin and sold short
- Priced continuously throughout the trading day
Open-End vs Closed-End Comparison
| Feature | Open-End (Mutual Fund) | Closed-End Fund |
|---|---|---|
| Shares outstanding | Variable (unlimited) | Fixed |
| Pricing | NAV (once daily, forward pricing) | Market price (continuous, exchange-traded) |
| Buy/sell | From/to the fund company | On an exchange (secondary market) |
| Premium/discount | Always at NAV (+ sales charge) | Can trade above or below NAV |
| Leverage | Not permitted | Permitted |
| Margin/short selling | Not permitted | Permitted |
| Redemption | Fund redeems within 7 calendar days | No redemption; sell on exchange |
| IPO | Continuous offering | One-time IPO |
Exam Tip: Gotchas
- Closed-end funds commonly trade at a DISCOUNT to NAV. When the exam describes a fund trading at 95% of NAV, think closed-end fund (or ETF in rare cases). Conventional mutual funds always transact at NAV.
What Should You Check on Exam Day?
- Can you name whether a fact pattern describes an open-end fund, a closed-end fund, or neither, based only on how shares are bought, sold, and priced?
- Do you know the NAV formula and can you apply forward pricing to a cutoff-time scenario?
- Do you know that the POP equals NAV plus the sales charge, and that redemption always happens at NAV?
- Can you recall the 7-calendar-day redemption deadline and the 75/5/10 diversification test?
- Do you remember that the single-class-of-common-stock rule limits how an open-end fund raises its own capital, not what it can hold in its portfolio?
- Can you list which structure permits margin and short selling (closed-end) and which does not (open-end)?